U.S. Tariffs Threaten Germany’s Export-Driven Economy, as Nation Allows Greater Borrowing

Germany’s economy contracted by 0.1% in Q2 2025, reversing a 0.3% expansion in Q1, as U.S. demand slowed after a period of strong purchases driven by anticipated tariff hikes. The decline aligns with forecasts and reflects reduced investment in equipment and construction, though consumption and government spending rose.

Uncertainty over U.S. tariffs, which include a 15% levy on EU goods and higher sectoral tariffs on autos, steel, and aluminum, has weighed heavily on Germany, a major exporter. The eurozone, however, saw a better-than-expected 0.1% growth, suggesting some resilience.

Analysts warn that ongoing trade tensions and potential new tariffs could push Germany toward a third consecutive year of stagnation or recession, with exports to the U.S., a key market, dropping significantly. A new trade framework with the U.S. offers some relief, but broader structural issues and global uncertainty continue to challenge growth prospects.

The economic contraction and ongoing stagnation signal persistent structural challenges, including high energy costs, bureaucratic burdens, and geopolitical tensions. These factors reduce Germany’s attractiveness as an investment destination, particularly for smaller and medium-sized enterprises.

Multinationals, however, may continue to invest in larger projects to secure European value chains, as seen with FDI inflows reaching €46 billion in the first four months of 2025, driven by intra-company debt flows. Uncertainty surrounding U.S. tariffs and global trade tensions, particularly with the U.S. and China, discourages FDI, as investors adopt a cautious “wait-and-see” approach.

In contrast, sectors like semiconductors and pharmaceuticals see selective investment (e.g., TSMC’s €10 billion fab in Dresden). Germany’s green energy transition, supported by €6 billion annually for climate protection by 2025, may attract FDI in green technologies, but skepticism about the growth potential of decarbonization efforts could limit this.

Germany’s low public investment (2.8% of GDP, below the EU average of 3.6%) and bureaucratic red tape (e.g., 120 days to obtain a business license) deter FDI. The proposed €500 billion infrastructure fund could boost FDI by signaling government commitment to growth, but its impact is not expected until 2026.

Germany’s stable legal environment and skilled workforce remain attractive, but competition from Central and Eastern European countries (e.g., Poland, Hungary) with lower costs and higher growth is diverting FDI. Germany’s outward FDI is increasingly sensitive to geopolitical risks, particularly in energy-intensive sectors and with countries like China and Russia. Inward FDI from China has declined, reflecting global fragmentation.

Tighter screening of foreign investments in critical sectors (e.g., AI, semiconductors) may limit FDI inflows from non-EU countries. German exports fell by 1.4% in May 2025, with a sharp 7.7% drop to the U.S. and a 13.8% year-on-year decline, driven by tariff uncertainty. The U.S., Germany’s largest trading partner, accounts for a €65 billion trade surplus, making it vulnerable to proposed 15% tariffs on EU goods and higher sectoral tariffs.

Exports are projected to contract by 1.9% in 2025, marking a third consecutive year of decline, exacerbated by reduced demand from China and global trade tensions. U.S. tariffs threaten Germany’s export-driven economy, where goods exports account for 36.1% of GDP. The automotive sector, a cornerstone of German exports, faces challenges from both U.S. tariffs and competition from Chinese EV manufacturers supported by “Made in China 2025.”

The BDI industry association estimates that U.S. tariffs could shrink Germany’s economy by 0.5% in 2025, further dampening export prospects. Germany’s reliance on intra-EU trade (a key stabilizer) may grow as transatlantic trade weakens. Deeper EU integration is critical to offset U.S. tariff impacts, though Chinese goods redirected to Europe due to U.S.-China trade tensions could oversaturate markets.

The EU Commission is urged to pursue new trade agreements to maintain and expand market access. High energy costs and declining competitiveness in key industries (e.g., automotive, chemicals) undermine export performance. Layoffs by major firms like Bosch and Siemens (over 60,000 jobs cut in 2024) signal reduced production capacity. The government’s forecast predicts a 0.3% export decline in 2025, driven by global uncertainties and weakened competitiveness.

Germany’s government must address bureaucratic inefficiencies and boost public investment to restore FDI appeal. The €500 billion infrastructure fund and potential debt brake reform could signal a shift, but effects are delayed. Mitigating tariff impacts requires stronger EU trade agreements and diversification of export markets. Investments in green technologies and digitalization could enhance competitiveness, but structural reforms are critical to avoid a third year of recession.

Germany’s Strict Fiscal Rule To Allow Greater Borrowing And Investment in 2026

The German Cabinet approved the 2026 draft budget, featuring a total spending of €520.5 billion, with record investments of €126.7 billion and borrowing of €174.3 billion, tripling the 2024 borrowing of €50.5 billion. This includes €117.2 billion for defense, set to rise to €161.8 billion by 2029, supported by a debt brake reform and a €100 billion special defense fund. A €500 billion infrastructure fund will add €58.9 billion in borrowing for 2026.

The budget aims to revive economic growth, modernize infrastructure, and boost military spending, with parliamentary discussions starting in September and approval expected by year-end. Finance Minister Lars Klingbeil warned of austerity measures from 2027 due to a projected €172 billion deficit through 2029.

The debt brake reform in Germany refers to changes made to the country’s constitutional debt brake (“Schuldenbremse”), a fiscal rule embedded in the German Constitution (Basic Law) since 2009. The debt brake limits the federal government’s structural budget deficit to 0.35% of GDP and generally prohibits deficits for state governments, with exceptions for emergencies or severe economic downturns.

The reform addresses Germany’s need for increased public investment in areas like defense, infrastructure, and climate initiatives, especially after years of underinvestment and amid economic stagnation. It balances the constitutional commitment to fiscal restraint with the necessity to fund modernization and meet NATO defense spending targets (2% of GDP).

The reform allows for higher borrowing in 2026 (€174.3 billion, up from €50.5 billion in 2024) by adjusting how the debt brake is applied, possibly through a broader interpretation of “exceptional circumstances” or recalibrating the structural deficit limit. A new €500 billion infrastructure fund was introduced, enabling €58.9 billion in borrowing for 2026 to finance projects like rail, renewable energy, and digitalization, which are treated separately from the regular budget to bypass strict debt brake limits.

The reform facilitates the use of a €100 billion special defense fund (created in 2022) and increased defense allocations (€117.2 billion in 2026, rising to €161.8 billion by 2029), ensuring compliance with NATO commitments without fully counting against the debt brake’s cap. The reform may refine how economic cycles are factored into deficit calculations, allowing more flexibility during economic recovery phases.

The debt brake typically caps structural deficits but permits higher borrowing during crises (e.g., natural disasters, pandemics, or recessions). The reform likely expands these exceptions or adjusts the formula for calculating permissible deficits, possibly by accounting for long-term investment needs or off-budget special funds.

Special funds (like the defense and infrastructure funds) are structured to comply with the debt brake by being legally separate from the federal budget, thus not counting toward the 0.35% GDP limit. Germany faces pressure to stimulate its economy, which has lagged in recent years. Investments in infrastructure and green technology aim to boost competitiveness.

Rising defense spending reflects commitments to NATO and regional security amid global tensions. The reform maintains the debt brake’s core principle of limiting deficits to avoid unsustainable debt, with Finance Minister Lars Klingbeil signaling austerity measures from 2027 to address a projected €172 billion deficit through 2029.

Some argue the reform weakens fiscal discipline, risking higher debt levels, while others say it doesn’t go far enough to address investment needs. The increased borrowing in 2026 raises concerns about future budget cuts, as the government plans to reduce deficits post-2026 to comply with the debt brake’s long-term constraints.

The debt brake reform adjusts Germany’s strict fiscal rule to allow greater borrowing and investment in 2026, particularly for defense and infrastructure, through mechanisms like special funds and a loosened interpretation of deficit limits. It aims to balance economic stimulus with fiscal responsibility, though it sets the stage for potential austerity measures after 2026 to manage rising deficits.